The Inevitable Collapse of China's Banks

Includes: CAF, FXI, PGJ
by: Nicholas Vardy

Chinese banks were the belles at the global investment ball in 2006. The Industrial and Commercial Bank of China [ICBC] overtook Bank of America (NYSE:BAC) on the last trading day of 2006 to become the second-biggest bank in the world in terms of market capitalization. Last year, no fewer than three Chinese banks were catapulted into the ranks of the world's ten-largest banks by market value. With 41% of the Shares FTSE/Xinhua China 25 Index (NYSEARCA:FXI) made up by Chinese financial stocks, the explosion in the value of these three banks largely is responsible for the index's meteoric rise last year.


Chinese Banks: The Biggest Extreme Makeover... Ever

Western investment banks have done a remarkable job re-branding Chinese banks. Until 2005, Chinese banks were widely recognized as unwieldy state-owned lenders run by Chinese Communist Party apparatchiks, known more for a legacy of bad debts rather than for their world class commercial acumen.

Here's the irony. Chinese megabanks aren't even banks -- at least not the way we understand them. Carved out of the old Communist banking system just over 10 years ago, the state-owned banks' role has been to bankroll the government's massive infrastructure projects and to keep otherwise bankrupt state-owned enterprises [SOEs] afloat. As arms of the Communist government, Chinese banks have had no incentive to learn the disciplines of basic banking. Conversely, loan applicants never had to cobble together a business plan to get a loan -- or suffer the negative consequences of failure.

That's why it's no surprise that Chinese state-owned banks are a commercial disaster. The Chinese government has pumped over $434 billion to bail them out -- just since 1998. That's more than the GDP of banking giant Switzerland. The U.S. Savings & Loan scandal of the early 1990s cost to the U.S government barely registers in comparison. Add to that the estimated $358 billion in bad loans that China's four-largest banks officially have on their books today, and something smells rotten in Shanghai.

Gleaming new corporate headquarters notwithstanding, don't underestimate the backwardness of China's banks. The Bank of China does not have a centralized computer system to keep track of its client accounts. Corruption is ubiquitous. Its prospectus outlined fraud amounting to $737 million. Last April, it fired 75 bank officials for corruption and one former branch head was even given a (suspended) death sentence. And if you believe that the fish rots from its head, consider that the CEO of each Chinese megabank is a Communist Party crony.

The Coming Collapse: Truth... or Consequences

Peek behind the Wizard of Oz's (or Shanghai's) curtain, and you'll see that China's double-digit percentage growth rates are an economic sleight of hand that have come at a price of escalating bad debt and non-performing loans. At the end of 2004, bank debt in China stood at $3.7 trillion -- about twice the size of its GDP. That's the highest proportion of any economy in the world. And that debt is lent almost entirely by state-owned banks -- and over half of it by the Big Four. Today, Chinese state-owned enterprises [SOEs] owe banks over $2 trillion -- about the size of the entire Chinese economy. And the amount of outstanding loans is growing by $500 billion each year.

None of this will shock any student of Communist economies. This is just the way financial institutions in "soft budget constraint" socialist economies work. That is the insight of Communist Eastern Europe's only Nobel Prize caliber economist (and now Harvard professor), the Hungarian Janos Kornai. In socialist economies, cheap loans combined keep inefficient state-owned enterprise afloat. They also mean that a lot of goods are produced that shouldn't be produced in the first place. Throw in China's cheap labor and you see why the Chinese are selling Honda knock-off motorcycles at the price of their weight in scrap metal in Vietnam. This may lead to impressive rates of "top-line" economic growth in the medium term. But it also leads to the kind of massive misallocation of resources that eventually brought the Soviet Empire to its knees.

This makes the coming collapse of Chinese banks inevitable. And it won't be the first time it will have happened. In the Asian crisis of 1997, two Guandong banks went belly up -- exposing the massive non-performing loans given to the Chinese red chips floated in Hong Kong. Of course, investment bankers flogging shares of China's state-owned banks will tell you "this time it's different." But ply them with drinks at a Hong Kong hotel bar and they'll admit that much of the improvement in the balance sheets of China's banks comes from re-classifying hundreds of billions' worth of risky loans from "non-performing" to "special mention" -- and not because of any genuine change in lending practices.

Indeed, when Ernst & Young suggested in 2005 that banks' bad debts in China might amount to as much as $911 billion, the Chinese government quickly suppressed the report. That should be no surprise. Repressing the truth is what Communist governments are best at. But the next time you hear about China's $1 trillion of foreign reserves, remember that this world record stash is barely enough to pay off its bad banking debts. And with cheap loans financing a big chunk of China's 10%+ annual economic expansion, bad debts may approach $2 trillion before the bubble bursts.

Think of the Chinese economy like the bus in the movie "Speed." The Chinese economy is like the bus that has been rigged with explosives. If its speed drops to below 50 mph, it will explode. The Chinese authorities' challenge is to keep the bus going above 50 mph until the bomb can be (somehow) defused. If economic growth does slow, SOEs won't be able to service their debts and the entire banking system will collapse on itself. And even $1 trillion won't be enough to save it.

Here's what's worrisome. The Chinese bus will eventually run out of gas. And the Chinese economy plays a much bigger role in the global economy than it did during the Asian Crisis of 1997. China's troubles will have a much greater impact on the U.S. economy than the collapse of the Soviet Union -- an economy that accounted for less than 1% of U.S. trade in 1991.

Ironically, it is not the inevitable rise of China's banks that poses the greatest challenge to the global economy. But rather, it's their inevitable collapse.

Disclosure: Author has no position in above-mentioned stocks.